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Why the Aging Bull May Still Have Legs

As I pen this blog, the DJIA is at all-time highs, and the S&P 500 is within striking distance of breaking out of its resistance near 1900. I still maintain that “cautious optimism” is the word of the day, so I want to outline some reasons why these markets may surprise everyone by continuing on their longer term bullish trajectory in the second half of 2014.

I begin my thesis with the notion of “sell in May, go away”. This is one of the oldest adages in the stock market game. History comes into play here as the summer doldrums months of May – October typically yield significantly lower returns than the remainder of the year. This year, the number of searches relating to “sell in May” are just about double the average of the last nine years. One could argue that it seems everyone is looking for a correction in the near-term. However, we need to keep in mind that historically, the market displays a tendency to frustrate the masses at every turn. So with just about everyone on the street looking for a meaningful decline to begin at any moment, it looks like those looking to sell in May are in the majority and may provide the first possible catalyst for higher stock markets as they scramble to either cover short positions or get long the market on a technical breakout to new highs.

The second potential catalyst for higher stock prices is what I like to call the “weather payback”. We have seen the effects of the brutal winter of 2014 across the board when we look at recent earnings reports and downward revisions to first quarter GDP. With these extreme winter weather conditions, individuals changed their consumption behavior – but perhaps only for a time. It stands to reason that if the underlying economy is continuing to heal slowly, the purchases of things like automobiles, furniture and clothing were simply delayed and will, therefore, carry forward into the second quarter. As a result of the weather payback, it is very possible that just as GDP growth surprised to the downside in the first quarter it will surprise to the upside in the next few quarters. Additionally, employment seems to be firming and financial conditions are improving. Financial uncertainty is being reduced. All of this points to a possible continuation of the bullish run.

The third reason the markets may break out to the upside involves “big money” positioning in the markets. According to a recent survey, global investors have raised their cash holdings to a two-year high as they cut equity exposure. Managers now have as much as 5% of their portfolios in cash on average. Asset allocators are also reducing their weighting in equities that have fallen from 45% last month to 37% in April. This leaves a good deal of capital “on the sidelines” that could potentially lead to underperformance by professional money managers if the markets breakout to new highs. They don’t want to miss the “alpha” or opportunity to outperform the overall indices by being sidelined during a further market “melt-up”. An influx of this sort of capital could drive prices higher, perhaps rather quickly if a true chase for performance starts to come into play.

The fourth and final rationale for markets to head higher involves the potential for inflation to continue to be benign, therefore allowing the Fed to maintain its low rate policy. I’ve been anticipating inflationary pressures to come back into play for a while now, yet the ten-year yields started 2014 around 3% and are now down to 2.6%. I believe that despite the reduction in quantitative easing the Fed’s bond buying is still making up a huge chunk of the reason interest rates are going lower. Despite the Fed pulling back on bond buying, interest rates have not shot up like they did in the latter half of 2013. If inflation comes in lower than expectations, then interest rates may remain very low which allows fixed-income investments to maintain value. As a result of lower than expected interest rates, the P/E multiple of the market could move higher.

Your investing/trading decisions should always begin with an educated thesis of current market conditions and their impact on your underlying companies’ abilities to generate profits going forward. Arguments can be made that things are gradually improving within our economy which will continue to support equity prices. If and when we start to notice that good underlying economic news no longer fuels higher prices, we may arrive at a tipping point for the markets. We don’t seem to be at that point quite yet, but I will keep my radar tuned for just this sort of occurrence.